FA2: Module 10
PPE and intangible assets: Depreciation,
amortization and impairment
1. Amortization
2. Impairment
3. Goodwill impairment
1. Amortization of capital assets
Since long-lived assets provide benefits over several
years, the cost is allocated (matched) to the periods in
which service are received from (revenues and cash
flows are generated by) the asset.
Amortization is called:
Depreciation
Depletion
Amortization
When referring to:
Property, plant & equipment
Natural resources
Intangible capital assets
Amortization expense is not a reflection of a decline in
market value of the asset. Amortization expense is not a
cash outflow.
Capital assets with an indefinite useful life (e. g., land,
some intangibles) are not subject to amortization.
Calculating amortization
1. Determine acquisition cost
= purchase price + any expenditures reasonable and
necessary to put the asset into service.
2. Estimate useful service life and residual value
(expected value at end of useful service life, often
assumed to be zero for convenience). Note that the
asset’s physical life may extend beyond its service
life.
3. 3. Decide upon the pattern of revenue generation of
asset (i. e., select an amortization method):
– Straight-line
– Diminishing-balance (Declining-balance)
– Units-of-production or units-of-use
Amortization methods
1. Straight line method
Calculation of amortization expense
= (Cost - residual value)/Estimated service life
Comments
• simple and easy to use,
• by far the most popular amortization method.
• amortization expense is the same in every year
(except perhaps years of acquisition and disposal)
• appropriate if asset provides constant level of
benefits throughout its useful life
Amortization methods
2. Diminishing-balance (declining-balance)
Calculation of amortization expense
= Asset book value (cost – accumulated
amortization) × rate
• a type of “accelerated” amortization, generating
higher expense in early years of the asset’s life
• Appropriate if asset efficiency and earning power
decline as the asset ages
• Popular form is double-diminishing-balance
(DDB), where rate = (1/useful life in years) X 2
• Stop amortizing once asset book value equals its
residual value
• Used by Canada Revenue Agency (CRA) for
capital cost allowance purposes
Amortization methods
3. Amortization based on units (e. g., units-ofproduction)
Calculation of amortization expense
= Units realized this period X unit rate, where
Unit rate = (cost-residual value)/est. total units.
Units is a measure of capacity of the asset, either in
terms of service (e. g., hours of operation, kilometers)
or production (e. g., finished goods produced).
• Many argue that this method provides the best
matching of the cost of the asset with the benefits
derived from it.
• The units-of-production method is typically used to
record depletion of natural resources.
Example: Machine Ltd.
Machine Ltd purchased a machine on June 30, 20x3
for $50,000. It is estimated that the machine will
have a $10,000 residual value at the end of its service
life of 10 years (or approximately 10,000 operating
hours). Depreciation is computed to the nearest
month. Compute depreciation expense for 20x3 and
20x4 (assume a December 31 fiscal year end) using
each of the following methods:
a) straight-line
b) units-of-production based on working hours
(hours of operation were 1,000 in 20x3 and 1,500
in 20x4)
c) double-diminishing balance
Which method should be used?
Generally, the preferred method is the one that best
reflects the benefits the asset generates. If no single
method is better than the others in this regard, the
preferred method is the simplest one (usually, the
straight-line method).
200 Canadian public company amortization methods 2006
Straight-line (SL) only
95
Diminishing-balance (DB) only
3
Units-of-production only
11
SL and units-of-production
42
SL and DB
32
Units-of-production and DB
5
SL, DB and units of production
1
Changes in amortization
Companies may (and should) periodically revise
estimates used in the amortization calculation.
Specifically, the estimated residual value may change;
the estimated useful life may need to be revised; or
the pattern of use of the asset might change, implying
the need to change the amortization method.
Accounting for a change in estimate is done
prospectively (i. e., there are no changes in previous
years’ amortization). The appropriate treatment is to
amortize the remaining book value less the revised
estimate of the residual value over the (updated)
remaining useful life.
Example: G and S Moving Company
The G and S Moving Company has one truck, whose
original cost was $23,000. Its estimated residual value
was $3,000 and its estimated useful life was 4 years.
At the end of two years, its net book value was
$13,000 ( G&S uses straight-line depreciation). After
reviewing the use and current condition of the vehicle,
the company now believes that the total useful life of
the truck will be 5 years, after which its estimated
residual value will be $1,000.
Required
Show the entries to record depreciation expense for
year 3.
2. Impairment
Long-lived assets stay on the company’s
books for many years, but their ability to
generate cash flows can change due to
environmental factors.
Companies must watch for indications that
there has been an impairment, a situation in
which the recoverable amount of an asset or
group of assets has declined and, if necessary,
record an impairment loss.
Impairment losses
An impairment loss occurs if the carrying
value of an asset or group of assets exceeds
the recoverable amount.
Carrying value = cost less accumulated
depreciation less accumulated impairment
losses
Recoverable amount = (1) fair value less cost
to sell, or (2) present value of cash flows from
future normal use of asset, whichever is
higher
Cash-generating units
Impairment tests are typically applied to cashgenerating units, the smallest group of assets
in the organization that generates cash flows
that can be distinguished from the cash flows
of other assets or groups of assets.
If an impairment loss is identified with a
particular cash-generating unit, the total
impairment loss is allocated to the individual
assets within the group.
Steps in impairment testing
1. Identification of an asset or cashgenerating unit.
2. Review of external and internal
impairment indicators.
3. If required annual testing (goodwill,
indefinite life intangibles) or if indication
of impairment, measurement of
recoverable amount.
4. If impairment, write down to recoverable
amount and allocate impairment loss.
Impairment indicators
1. Significant change in business
environment
2. Physical damage to asset
3. History of operating and/or cash flow
losses
4. Probability > 50% that company will retire
or dispose of asset earlier than planned
5. Loss of patent infringement lawsuit that
has implications for overall operation
Allocation of impairment loss
If the loss is associated with a single asset,
charge all of the loss to that asset.
If the loss is associated with several assets in a
cash generating unit, loss is prorated among
assets based on carrying value.
Dr. Impairment loss
Cr. Accumulated depreciation – Asset A
Cr. Accumulated depreciation – Asset B
etc.
Limits to impairment loss allocation
1. No asset can be written down to a carrying
value less than zero.
2. No asset should be written down to a value
less than the higher of its fair value less
cost to sell or its value-in-use, as long as
this value is readily determinable.
Impairment losses can be reversed up to
original value. Reversal is allocated to
individual assets, prorated on carrying value
of the assets in the group.
Example: A10-25
3. Goodwill impairment
Use the same approach as for cash generating
units without goodwill (except that goodwill
must be tested for impairment every year).
Impairment losses are allocated first to
goodwill until goodwill reduced to zero, then
allocated to other assets in normal fashion.
Impairment losses charged to goodwill cannot
be reversed.
Example: A10-26